A Kid-Friendly Tax Shelter to Consider Before April 18
By Nilus Mattive | March 31, 2011 |

In my last few columns I’ve been talking about a number of ways you can both save for retirement and reduce your tax burden.

But today I want to talk about one more type of tax shelter that’s great for a child in your life — whether it’s a son, a granddaughter, or even a niece. In fact, I’ve been using this very same type of account for my daughter Vela since she was born in 2007.

It’s Called a Coverdell ESA, And Here’s How It Works …

Yes, the name sounds pretty intimidating … but what is now called a Coverdell Education Savings Account used to be known simply as an Education IRA. I guess lawmakers later decided that calling it a retirement account was silly since these things have to be used by age 30. Either that or they were looking for something to name after yet another Senator (in this case, Paul Coverdell of Georgia)!

Of course no matter what you want to call it, the Coverdell account does function very much like Roth IRAs designed for young students.

Like Roth IRAs, they allow you to sock away money — $2,000 a year, in this case — by tax day. And like Roth IRAs, as long as the funds are used for the benefit of schooling costs, any returns earned in the account will be distributed free of additional taxation going forward.

While that’s not an eye-popping number, it’s still a nice start and will add up over time. Plus, it’s perfect for using any tax refund money you receive.

Meanwhile, don’t underestimate the benefit of that tax shelter! Heck, let’s say you happened to put $2,000 into your child’s Coverdell account and invested it so wisely that within ten years it had miraculously turned into $200,000. That full amount would be available to pay for your kid’s education, and not one penny of taxes would need to be paid as you pulled it out!

Another cool feature of Coverdell accounts is that — unlike ever-popular 529 Plans — they can be used for expenses related to all types of schooling: High-priced pre-K classes, private secondary education, and many associated costs such as computers and books. It’s worth noting that this feature was set to expire in 2010 — but as part of the recent tax package, it has now been extended.

The contribution limit was also set to drop down to just $500 a year in 2011, but the tax package also extended the $2,000-a-year limit through 2012.

What about income restrictions, you ask?

A Coverdell can be a great way to save some money for future education expenses.
A Coverdell can be a great way to save some money for future education expenses.

Well, like the Roth IRA there are some caps to be aware of: Technically, you cannot fund a Coverdell if you have MAGI above $110,000 filing singly or $190,000 married filing jointly. Phase-outs kick in at lower levels, too.

But here’s where it gets interesting — even a child with no earned income can contribute to a Coverdell!

So if you’re above the income threshold, you can just gift the $2,000 to the child under the Uniform Transfer to Minors Act and they can put it in the Coverdell themselves.

Yes, it’s a stupid formality, but if it works in your favor, go with it!

And again, please note that you can establish a Coverdell for ANY child in your life — not just a direct relative but even a friend’s child or grandchild. Corporations and trusts are also free to establish Coverdells.

The only thing to know is that the Coverdell’s beneficiary can only have $2,000 contributed to his or her account in any given year. So you should always ask whether an account already exists and how much has been deposited before establishing one on your own. Contributions must also be made before the beneficiary turns 18.

As I noted earlier, a Coverdell beneficiary has to use the funds before turning age 30, or else taxes and penalties will likely be owed. However, the account can always be switched to another beneficiary before then — even if the new recipient is between ages 18 and 30!

Bottom line: You don’t get the potential for tax deductions that you do with 529 plans, but as you can see, Coverdells are a unique way to sock away a little extra money for someone special. And they can be fully funded in addition to 529 plans. So if you’re an aggressive saver and planner, they are definitely worth investigating no matter what.

If you’re interested in establishing a Coverdell, just check with your regular brokerage house or other financial institution. Most offer them, and it’s just a matter of completing some simple paperwork. But remember, you only have a couple weeks left to open one for the 2010 tax year!

--Nilus Mattive Source: Money and Markets

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